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Chapter Thirteen. Return, Risk, and the Security Market Line. Chapter Outline. Expected Returns and Variances Portfolios Announcements, Surprises, and Expected Returns Risk: Systematic and Unsystematic Diversification and Portfolio Risk Systematic Risk and Beta The Security Market Line - PowerPoint PPT Presentation
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© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
Return, Risk, and the Security Market Line
Chapter
Thirteen
Chapter Outline
• Expected Returns and Variances• Portfolios• Announcements, Surprises, and Expected Returns• Risk: Systematic and Unsystematic• Diversification and Portfolio Risk• Systematic Risk and Beta• The Security Market Line• The SML and the Cost of Capital: A Preview
Background/Big Picture:
• Investor rationality– Investors are assumed to prefer more money to less and less risk
to more, all else equal. The result of this assumption is that the ex ante risk-return trade-off will be upward sloping.
• As risk-averse return-seekers, investors will take actions consistent with the rationality assumptions. – They will require higher returns to invest in riskier assets and are
willing to accept lower returns on less risky assets.
• Two options– Seek to reduce risk while attaining the desired level of return
– Increase return without exceeding the maximum acceptable level of risk.
Expected Returns
• Expected returns are based on the probabilities of possible outcomes
• In this context, “expected” means average if the process is repeated many times
• The “expected” return does not even have to be a possible return
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Example: Expected Returns
• Suppose you have predicted the following returns for stocks C and T in three possible states of nature. What are the expected returns?– State Probability C T– Boom 0.3 0.15 0.25– Normal 0.5 0.10 0.20– Recession ??? 0.02 0.01
• RC = .3(.15) + .5(.10) + .2(.02) = .099 = 9.99%• RT = .3(.25) + .5(.20) + .2(.01) = .177 = 17.7%
Variance and Standard Deviation
• Variance and standard deviation still measure the volatility of returns
• Using unequal probabilities for the entire range of possibilities
• Weighted average of squared deviations
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Example: Variance and Standard Deviation
• Consider the previous example. What are the variance and standard deviation for each stock?
• Stock C 2 = .3(.15-.099)2 + .5(.1-.099)2 + .2(.02-.099)2
= .002029 = .045
• Stock T 2 = .3(.25-.177)2 + .5(.2-.177)2 + .2(.01-.177)2
= .007441 = .0863
Another Example
• Consider the following information:– State Probability ABC, Inc.– Boom .25 .15– Normal .50 .08– Slowdown .15 .04– Recession .10 -.03
• What is the expected return?
• What is the variance?
• What is the standard deviation?
Another Example
• Consider the following information:– State Probability ABC, Inc.
– Boom .25 .15
– Normal . 50 .08
– Slowdown .15 .04
– Recession .10 -.03
• What is the expected return?– E(R) = .25(.15) + .5(.08) + .15(.04) + .1(-.03) = .0805
• What is the variance?– Variance = .25(.15-.0805)2 + .5(.08-.0805)2 + .15(.04-.0805)2
+ .1(-.03-.0805)2 = .00267475
• What is the standard deviation? – Standard Deviation = .051717985
Portfolios
• A portfolio is a collection of assets
• An asset’s risk and return is important in how it affects the risk and return of the portfolio
• The risk-return trade-off for a portfolio is measured by the portfolio expected return and standard deviation, just as with individual assets
Portfolio Expected Returns
• The expected return of a portfolio is the weighted average of the expected returns for each asset in the portfolio
• You can also find the expected return by finding the portfolio return in each possible state and computing the expected value as we did with individual securities
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Portfolio Variance
• Compute the portfolio return for each state:RP = w1R1 + w2R2 + … + wmRm
• Compute the expected portfolio return using the same formula as for an individual asset
• Compute the portfolio variance and standard deviation using the same formulas as for an individual asset
Example: Portfolio Variance
• Consider the following information– Invest 50% of your money in Asset A– State Probability A B– Boom .4 30% -5%– Bust .6 -10% 25%
• What is the expected return and standard deviation for each asset?
• What is the expected return and standard deviation for the portfolio?
Portfolio12.5%7.5%
Detailed Solution
• Portfolio return in boom = .5(30) + .5(-5) = 12.5• Portfolio return in bust = .5(-10) + .5(25) = 7.5• Expected return = .4(12.5) + .6(7.5) = 9.5 or• Expected return = .5(6) + .5(13) = 9.5• Variance of portfolio = .4(12.5-9.5)2 + .6(7.5-9.5)2 = 6• Standard deviation = 2.45%• Note that the variance is NOT equal to .5(384) + .5(216) =
300 and• Standard deviation is NOT equal to .5(19.6) + .5(14.7)
= 17.17%
• What would the expected return and standard deviation for the portfolio be if we invested 3/7 of our money in A and 4/7 in B? Portfolio return = 10% and standard deviation = 0
Another Example
• Consider the following information– State Probability X Z– Boom .25 15% 10%– Normal .60 10% 9%– Recession .15 5% 10%
• What is the expected return and standard deviation for a portfolio with an investment of $6000 in asset X and $4000 in asset Y?
Detailed Solution
• Portfolio return in Boom: .6(15) + .4(10) = 13%• Portfolio return in Normal: .6(10) + .4(9) = 9.6%• Portfolio return in Recession: .6(5) + .4(10) = 7%
• Expected return = .25(13) + .6(9.6) + .15(7) = 10.06%• Variance = .25(13-10.06)2 + .6(9.6-10.06)2 + .15(7-10.06)2 =
3.6924• Standard deviation = 1.92%
• Compare to return on X of 10.5% and standard deviation of 3.12%
• And return on Z of 9.4% and standard deviation of .48%
Expected versus Unexpected Returns
• Realized returns are generally not equal to expected returns
• There is the expected component and the unexpected component
Expected Returns
• “Discounted” information used by the market to estimate the expected return
• Already included in the expected return (and the price).
• Note tie-in to efficient markets. Assumption: markets are semistrong efficient.
Unexpected Returns
• At any point in time, the unexpected return can be either positive or negative
• Over time, the average of the unexpected component is zero
Announcements and News
• Announcements and news contain both an expected component and a surprise component
• It is the surprise component that affects a stock’s price and therefore its return
• This is very obvious when we watch how stock prices move when an unexpected announcement is made or earnings are different than anticipated
Efficient Markets
• Efficient markets are a result of investors trading on the unexpected portion of announcements
• The easier it is to trade on surprises, the more efficient the markets should be
• Efficient markets involve random price changes because we cannot predict surprises
Systematic Risk
• Risk factors that affect a large number of assets
• Also known as non-diversifiable risk or market risk
• Includes such things as changes in GDP, inflation, interest rates, etc.
Unsystematic Risk
• Risk factors that affect a limited number of assets
• Also known as unique risk and asset-specific risk
• Includes such things as labor strikes, part shortages, etc.
Returns
• Total Return = expected return + unexpected return
• Unexpected return = systematic portion + unsystematic portion
• Therefore, total return can be expressed as follows:
• Total Return = expected return + systematic portion + unsystematic portion
Diversification
• Portfolio diversification is the investment in several different asset classes or sectors
• Diversification is not just holding a lot of assets
• For example, if you own 50 internet stocks, you are not diversified
• However, if you own 50 stocks that span 20 different industries, then you are diversified
The Principle of Diversification
• Diversification can substantially reduce the variability of returns without an equivalent reduction in expected returns
• This reduction in risk arises because worse than expected returns from one asset are offset by better than expected returns from another
• However, there is a minimum level of risk that cannot be diversified away and that is the systematic portion
FIGURE 13.1
Diversifiable Risk
• The risk that can be eliminated by combining assets into a portfolio
• Often considered the same as unsystematic, unique or asset-specific risk
• If we hold only one asset, or assets in the same industry, then we are exposing ourselves to risk that we could diversify away
Total Risk
• Total risk = systematic risk + unsystematic risk
• The standard deviation of returns is a measure of total risk
• For well diversified portfolios, unsystematic risk is very small
• Consequently, the total risk for a diversified portfolio is essentially equivalent to the systematic risk
Systematic Risk Principle
• There is a reward for bearing risk
• There is not a reward for bearing risk unnecessarily
• The expected return on a risky asset depends only on that asset’s systematic risk since unsystematic risk can be diversified away
Measuring Systematic Risk
• How do we measure systematic risk?
• We use the beta coefficient to measure systematic risk
• What does beta tell us?– A beta of 1 implies the asset has the same
systematic risk as the overall market– A beta < 1 implies the asset has less systematic
risk than the overall market– A beta > 1 implies the asset has more systematic
risk than the overall market
Total versus Systematic Risk
• Consider the following information: Standard Deviation Beta– Security C 20% 1.25– Security K 30% 0.95
• Which security has more total risk?
• Which security has more systematic risk?
• Which security should have the higher expected return?
Portfolio Betas
• Portfolio variance is not a weighted average of the individual asset betas,
• Portfolio betas are a weighted average of the individual asset betas
Example: Portfolio Betas
• Consider the following example with the following four securities– Security Weight Beta– DCLK .133 3.69– KO .2 0.64– INTC .167 1.64– KEI .4 1.79
• What is the portfolio beta?• .133(3.69) + .2(.64) + .167(1.64) + .4(1.79) =
1.61
Beta and the Risk Premium
• Remember that the risk premium = expected return – risk-free rate
• The higher the beta, the greater the risk premium should be
• Can we define the relationship between the risk premium and beta so that we can estimate the expected return?– YES!
Example: Portfolio Expected Returns and Betas
0%
5%
10%
15%
20%
25%
30%
0 0.5 1 1.5 2 2.5 3
Beta
Exp
ecte
d R
etur
n
Rf
E(RA)
A
Reward-to-Risk Ratio: Definition and Example
• The reward-to-risk ratio is the slope of the line illustrated in the previous example– Slope = (E(RA) – Rf) / (A – 0)– Reward-to-risk ratio for previous example =
(20 – 8) / (1.6 – 0) = 7.5
• What if an asset has a reward-to-risk ratio of 8 (implying that the asset plots above the line)?
• What if an asset has a reward-to-risk ratio of 7 (implying that the asset plots below the line)?
Market Equilibrium
• In equilibrium, all assets and portfolios must have the same reward-to-risk ratio and they all must equal the reward-to-risk ratio for the market
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Security Market Line
• The security market line (SML) is the representation of market equilibrium
• The slope of the SML is the reward-to-risk ratio: (E(RM) – Rf) / M
• But since the beta for the market is ALWAYS equal to one, the slope can be rewritten
• Slope = E(RM) – Rf = market risk premium
The Capital Asset Pricing Model (CAPM)
• The capital asset pricing model defines the relationship between risk and return
• E(RA) = Rf + A(E(RM) – Rf)
• If we know an asset’s systematic risk, we can use the CAPM to determine its expected return
• This is true whether we are talking about financial assets or physical assets
Factors Affecting Expected Return
• Pure time value of money – measured by the risk-free rate
• Reward for bearing systematic risk – measured by the market risk premium
• Amount of systematic risk – measured by beta
Example - CAPM
• Consider the betas for each of the assets given earlier. If the risk-free rate is 4.5% and the market risk premium is 8.5%, what is the expected return for each?
Security Beta Expected Return
DCLK 3.69 4.5 + 3.69(8.5) = 35.865%
KO .64 4.5 + .64(8.5) = 9.940%
INTC 1.64 4.5 + 1.64(8.5) = 18.440%
KEI 1.79 4.5 + 1.79(8.5) = 19.715%
Quick Quiz
• How do you compute the expected return and standard deviation for an individual asset? For a portfolio?
• What is the difference between systematic and unsystematic risk?
• What type of risk is relevant for determining the expected return?
• Consider an asset with a beta of 1.2, a risk-free rate of 5% and a market return of 13%.– What is the reward-to-risk ratio in equilibrium?
– What is the expected return on the asset?